What do the Olympic Village in London and the Burj Khalifa in Dubai have in common? The answer is Islamic financing, or financing under Islamic principles.
Though still accounting for a small share of the global financial industry, Islamic finance is one of its fastest-growing segments, and its potential is far from exhausted. Islamic banking institutions now operate in over 50 countries and account for more than 15 percent of market share in nearly a dozen of them. Iran and Sudan have a full-fledged Islamic financial sector, in addition to Bangladesh, Brunei, Kuwait, Malaysia, Qatar, Saudi Arabia, the United Arab Emirates, and Yemen. In addition, sukuk, the Islamic equivalent of bonds, are now being used in a number of countries, including by the governments of Hong Kong, Luxembourg, the UK, and South Africa. The total assets of the global Islamic finance industry stood at an estimated 1.8 trillion US dollars at the end of 2013, and this figure is growing.
What can it achieve?
The expanding reach of Islamic finance promises to carry a number of potential benefits. For example, Islamic financial institutions are less exposed to crisis because of their risk-sharing features. Islamic finance by design provides better risk management on the part of both financial institutions and their customers, as they share risks, speculation is prohibited, and financing is asset-based and thus fully collateralized. A depositor has the choice to be an investor in the bank and share profits and risks with it, or they can choose to simply place the money in the bank for safeguarding but without receiving any financial return.
Another advantage is that by offering a form of banking that is in compliance with Shari’a rules, Islamic finance can attract a large number of people into the banking system who have previously refrained for religious reasons. Moreover, in Islamic finance there is greater incentive for lending to small- and medium-sized enterprises (SMEs) because of the risk-sharing nature of the industry. And sukuk can be an interesting alternative to large-scale investments in infrastructure, through public–private partnerships (PPP), again boosting the environment for private sector activity and job creation in general.
But while growing in scope, there are challenges for the industry to develop in a safe and sound manner. The IMF examined some of these issues in a recently published Staff Discussion Note, trying to understand under what circumstances the potential of Islamic Finance can be realized.
I would focus here on the following three areas:
First, when it comes to financial stability, it is important to build on progress in setting standards to harmonize the regulation and supervision of Islamic finance and to protect its consumers. Basically, regulators need to approach this topic by first recognizing the unique features of Islamic banking. For example, regulators should clarify that customers who opt to be investors are treated as such, and enjoy more say in governance as well as greater transparency in the determination of their payouts.
Secondly, more countries need to follow the example of Bahrain, Malaysia and Qatar and issue government sukuk, which would provide a benchmark for sukuk to be issued by the corporate sector. This would help Islamic banks and central banks better manage liquidity. And, as this instrument is well-suited to financing infrastructure, increased sukuk issuance could help narrow the large gap for infrastructure financing. Countries such as Malaysia, Saudi Arabia and the United Arab Emirates are already tapping into this market to expand electric power, telecommunications and transportation infrastructure.
Finally, Islamic banking has yet to develop its equity-like financing to spur greater access for SMEs to finance. Equity financing is a key component, for instance, in making investments in start-up companies viable. To promote the development of an equity market under Islamic finance, it is important that the industry ensures the regulatory framework and tax policies in different countries do not discriminate against risk-sharing. Also, this type of financing requires that banks develop the capacity to assess economic projects and their stewards, and therefore it is of paramount importance to strengthen the overall financial infrastructure.
And what is the role for international financial institutions?
While some of these issues will need to be resolved over time for the industry to develop and fulfill its social mandate, our role in responding to this increased demand was to initially bring different players to the same table to openly discuss some of these issues, then to identify the hurdles and come up with a shared understanding of where the future of Islamic finance lies.
The IMF has long been involved in Islamic finance, and will continue to be, through policy advice, capacity building, and outreach. In addition to our Staff Discussion Note, we held a seminar on this topic during the IMF’s Spring Meetings. While there are still unanswered questions, one thing is certain: international financial institutions and standard setting bodies have an important role in advancing the industry in a sound and sustainable manner.
For me personally, after participating in some of these meetings one thing is clear: there is a great deal of interest in “no interest.”